Case AxCess Unlimited

Transcription

1 Case 03-7 AxCess Unlimited AxCess Unlimited (AxCess) is a public company that develops customized encoded cardreading applications for security and access control devices. For the year ended December 31, 2003, AxCess has recognized $18 million of deferred tax assets (net of $2 million valuation allowance), which primarily consist of net operating loss and income tax credit carryforwards. The table below summarizes the deferred tax assets by category, as of December 31, 2003, and indicates the years over which the future tax benefits will expire if not used. AxCess (a) does not have any significant deferred tax liabilities, (b) is not permitted by tax law to carryback operating losses to income in prior years, and (c) is not permitted to carryback income tax credits to recover taxes paid in prior years. Historically, AxCess has utilized its net operating loss and income tax credit carryforwards prior to those benefits expiring unused. AxCess s effective tax rate is 40 percent. Deferred Tax Assets: (In millions) Expiration Period Federal net operating loss carryforwards $ * Federal and state income tax credits * Research and development credits * Subtotal $ 20.0 Less: Valuation allowance (2.0) Total deferred tax assets $ 18.0 * Amounts expire ratably over the expiration period. Upon reviewing the income tax audit workpapers for the year ended December 31, 2003, the engagement partner, Rob Williams, is concerned with AxCess s ability to realize the deferred tax assets because of cumulative losses experienced in recent years. Based on the five-year summary of Selected Historical Consolidated Financial Information (Handout 1), Rob is concerned that AxCess may not be able to generate sufficient future taxable income in order to utilize the net operating loss and income tax credit carryforwards before they expire. However, Company management believes that the $2 million valuation allowance is adequate and the controller of AxCess, Bill Purdom, has prepared a memorandum supporting management s assessment of the adequacy of the $2 million valuation allowance for the year ended December 31, 2003, which also has been included (Handout 2). Required: Is management s assessment of the $2 million valuation allowance appropriate for the year ended December 31, 2003?

2 Case 03-7: AxCess Unlimited HANDOUT 1 AXCESS UNLIMITED SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION Years Ended December 31 INCOME STATEMENT DATA (in millions): Cumulative 3 Years Net revenue (a) $ $ $ $ $ $ Cost of goods sold Inventory write-off (b) Gross Margin Operating Expenses: Selling and marketing Research and development Mergers and restructurings (c) Intangible asset amortization (d) Acquired in-process R&D (e) Total Operating Expenses Pretax income (loss) $ 2.1 $ 3.3 $ 2.9 $ (5.1) $ (3.3) $ (5.5) (a) (b) (c) (d) (e) The increase in revenues from 2001 to 2003 is the result of acquisitions completed during each of the years ended December 31, 2001 and 2002, and the introduction of I-Trak, a newly developed technology, during The $4.3 million represents inventory scrapped in connection with the introduction of I-Trak. Represents merger and restructuring charges incurred in connection with the acquisitions made during 2001 and Those charges primarily consist of the elimination of management, workforce, and facility redundancies. Represents amortization of intangible assets (e.g., technology and non-compete agreements) acquired during 2001 and The $2.1 million represents in-process research and development with no alternative future use acquired in 2002 and immediately written-off.

3 Page 1 AXCESS UNLIMITED MEMORANDUM To: Files From: Bill Purdom, Controller Date: January 20, 2004 Subject: Year End Valuation Allowance for Deferred Tax Assets This memorandum summarizes AxCess Unlimited s assessment of the $2 million valuation allowance recorded against deferred tax assets of $20 million as of December 31, Historical Earnings The five-year historical operating results, presented in the Selected Historical Consolidated Financial Information (Handout 1), indicate that a cumulative pretax loss of $5.5 million exists (calculated as the current year pretax loss plus the pretax income/loss of the immediate two preceding years). However, management believes the cumulative pretax loss is the result of certain events that occurred during those periods and are not representative of the Company s ability to generate future taxable income (in order to utilize the future tax benefits). Those events are described in (b) (e) in the Selected Historical Consolidated Financial Information (Handout 1). Except for the intangible asset amortization, management believes each of the events are nonrecurring and an aberration, rather than a continuing condition. Accordingly, we believe those nonrecurring events should be excluded from the analysis of historical earnings when making an assessment of the adequacy of the valuation allowance. An analysis of the historical earnings adjusted for the removal of these nonrecurring events is presented at the end of this memo. The analysis indicates that AxCess Unlimited will generate approximately $21.0 million ($2.1 million annual adjusted pretax income multiplied by 10 years) in pretax income on a historical basis over the period that the future tax benefits expire. We note also that our Company has a history of utilizing all net operating loss and income tax credit carryforwards prior to their expiration as a result of sufficient taxable income. TargetCo Acquisition On January 15, 2004, AxCess Unlimited announced it had signed a letter of intent to acquire TargetCo in a purchase business combination to be completed by April 30, TargetCo recently introduced RU-Mine, a state-of-the-art security system activated by unique fingerprint scans. RU-Mine has been well received in the market, and TargetCo has a portfolio of firm purchase commitments established with major distributors in the industry that management believes will ensure future revenues and taxable income.

4 Page 2 Based on the audited financial statements of TargetCo for the years ended December 31, 2001, 2002, and 2003, we expect TargetCo to contribute, on an annual basis, approximately $80.0 million and $1.7 million in revenues and pretax income respectively (calculated as the average of the three years ended December 31, 2003). Accordingly, we believe the acquisition will provide additional pretax income of approximately $17.0 million ($1.7 million projected pretax income multiplied by 10 years) over the period that the future tax benefits expire. See the Adjusted Historical Earnings below. Future Earnings Forecast Future revenues are projected to increase by 12 percent annually over the next five years (exclusive of the acquisition of TargetCo) primarily as the result of increased sales volume from the introduction of I-Trak during Operating costs are projected to decrease by five percent over the same period primarily due to reduced fixed costs from the restructuring programs implemented during the 2001 to 2003 time frame. Pretax income from continuing operations for the year ended December 31, 2004, is projected to be $3.3 million increasing to approximately $4.5 million for the year ended December 31, Accordingly, we believe AxCess Unlimited will generate between $12.0 million [($3.3 million projected pretax income less $2.1 adjusted historical pretax income) multiplied by 10 years] and $22 million in additional pretax income over the period which the future tax benefits expire. See the Adjusted Historical Earnings below. Adjusted Historical Earnings The following analysis presents the historical operating results adjusted for the nonrecurring events from 2001 to 2003 and management s estimates of future income from the items discussed above. The analysis then reconciles management s estimate of future taxable income that will be generated over the 10-year period to the amount of future tax benefits from net operating loss and income tax credit carryforwards expiring during the same period. As noted in the conclusion below, the $2 million valuation allowance represents the amount of research and development credits that management believes will expire unused. In order to utilize the net operating loss and income tax credit carryforwards, management believes AxCess Unlimited must generate $45 million [($18.0 million deferred tax assets from net operating loss and income tax credit carryforwards) divided by 40 percent tax rate] of future taxable income over the period that those benefits expire.

5 Page 3 ADJUSTED HISTORICAL EARNINGS Years Ended December 31, INCOME STATEMENT DATA (in millions): Cumulative 3 Years Pretax income (loss) $ 2.9 $ (5.1) $ (3.3) $ (5.5) Nonrecurring items not indicative of future operations: Inventory write-off Mergers and restructurings Acquired in-process R&D write-off Adjusted pretax income $ 4.6 $ 0.8 $ 1.0 $ 6.4 Average annual adjusted pretax income $ 2.1 SOURCES OF FUTURE TAXABLE INCOME: Adjusted historical pretax income ($2.1 million 10 years*) $ 21.0 Projected annual pretax income from TargetCo acquisition ($ years*) 17.0 Projected annual increase in pretax income from operations ($1.2 million 10 years*) 12.0 Total Estimated Future Taxable Income $ 50.0 Less: Deferred Tax Benefits as of December 31, 2003, expiring calculated as [($15.0 million NOLs + $3.0 million tax credits) 40 percent tax rate] 45.0 Excess Future Taxable Income $ 5.0 * Represents the number of years over which the future tax benefits expire ( ). Conclusion The amount of valuation allowance generally represents our actual experience of the amount of tax benefits that have expired unused. Historically, this amount consists of research and development credits, or similar credits, with expiration periods of three years or less and limited deductibility under tax law. Consistent with prior years, the $2 million valuation allowance represents the amount of research and development credits that management believes will expire unused. Based on the Adjusted Historical Earnings and the supporting basis for conclusions described above, it is management s conclusion that it is more likely than not that the future tax benefits related to the net operating loss and income tax credit carryforwards will be realized. The analysis indicates an excess $5 million of future taxable income over the amount of future tax benefits from net operating loss and income tax credit carryforwards expiring during the same period. Accordingly, we believe the $2 million valuation allowance appropriately reduces deferred tax assets to the amount more likely than not to be realized for the year ended December 31, 2003.